Posts from May 2013

Tuesday 21st May 2013

There’s an argument made that the reason the UK’s economy is struggling is because the government is cutting spending. This line of logic originates with the work of John Maynard Keynes, who theorised that economic output is influenced by the total amount of spending in the economy, called aggregate demand. He argued that aggregate demand drops in recessions, and that when this happens the government should provide fiscal stimulus to make up the shortfall.

A key signal of aggregate demand is the unemployment level: higher unemployment, lower aggregate demand. In other words: in a recession lots of people lose their jobs, and so there is less spending in the economy, therefore the government should spend more money to make up the difference.

It’s an interesting idea and it might even be true. However, it is argued that this is the situation that Britain is in now, and so more fiscal stimulus is needed to help the recovery. But that doesn’t really stack up.

The signal for aggregate demand is unemployment, and one of the curious things in Britain throughout the downturn is that unemployment hasn’t actually risen that much, compared to the change in economic output. In fact, the drop in labour productivity during the downturn has had a lot of economists somewhat puzzled.

So if unemployment hasn’t risen, there can’t be a problem with aggregate demand. Fiscal stimulus solves aggregate demand. So why do we want more fiscal stimulus?

In fact, you could possibly argue the opposite. Yes, there have been real cuts in government spending, but actually they haven’t been that significant. The British government is still spending a historically high amount, and still has one of the largest deficits in the world. So the government has been providing fiscal stimulus, and that’s why unemployment didn’t rise as much. It might be true, I have no idea. It’s an interesting idea though, and if it is true it surely vindicates a lot of the Keynesian viewpoint.